Tuesday, November 20 2012

We have seen the market sell off post Barack Obama’s re-election victory before a bounce overnight. The weakness can be attributed to nervousness about the “fiscal cliff”. The “fiscal cliff” is the agreement between the Republican Congress and the President whereby if they cannot come to an agreement regarding the debt ceiling then tax rises to the wealthy, defence cuts and welfare cuts kick in. This would be undesirable for both parties and likely lead to a 4% contraction in the US GDP. The election results have shown that Americans favour the status quo, but the deep political divide between the White House and a Republican-controlled House of Representatives adds complexity and uncertainty over fiscal policy. As such, stock prices have faced pressure until investors can get some clarity on how the “fiscal cliff” will be resolved.

As for President Obama’s victory, he has won by a wider-than-expected margin, which is demoralising for House Republicans who are probably more likely to make compromises. Already, House Speaker John Boehner has signalled his willingness to accept higher tax revenues as a part of a deficit-cutting deal. The bigger-than-expected win for Obama means that he now has a mandate. This could harden his approach and attitude when negotiating with the Republicans. However, it is also possible that having won the second term, president Obama no longer cares about his political base as much as before. This could make him more willing to reach out to Republicans and get a deal done. Certainly the early stage of negotiations seems to be progressing with both parties willing to demonstrate a desire to compromise. In the end, we believe that pragmatism will prevail.

However it is important to note that a pragmatic deal to end the fiscal cliff is still likely to mean a contraction in fiscal spending. The US needs to reduce its deficit and reduce debt. This means further reform of their healthcare system (they spend 23% of GDP on health compared to 14% for Australia), reform of taxation to broaden the tax base, and a reduction in entitlements. Essentially some compromise from both sides is required. This burden will place some downwards pressure on US economic growth (although we do think markets are anticipating this fact).

As an offset to this pressure we see two factors contributing to growth. Firstly we see an increase in capital expenditure as the US seeks to monetise the large gas resource they have found. Secondly we expect a recovery in the housing market. The November homebuilders’ sentiment report overnight provided further evidence that the residential construction market is gaining meaningful traction. The November figures showed a large five point jump to a 46 reading on the index, which is the highest level since May 2006.

Over the past twelve months National Association of Home Builders (NAHB) sentiment is up 27 points, which is the largest gain in any 12 month period on record. Importantly, the ongoing rise in sentiment has been broad-based. As shown in the chart below, the homebuilders’ sentiment index is highly predictive of housing starts with a lead on the former of approximately six months.

The correlation between the two series is over 90%. Based on history, the current 46 level of the NAHB index is consistent with annual housing starts of roughly 1.6 million units at an annual rate. This is roughly double the current 0.745 million year-to-date average. If the pace of housing starts increases over the next year by the amount that builders’ sentiment implies, then the contribution from residential construction in the GDP accounts should double, as well. The year-to-date contribution to real GDP has been 30 bps per quarter. This should increase to 60 bps per quarter next year given the scenario highlighted above (an additional 1.2% to GDP for the year). Additionally, higher consumption of housing-related services coupled with the indirect effects from home price appreciation (i.e. wealth effects) could easily raise the housing contribution to one full percentage point (2.8% additional GDP). In short, housing could provide a meaningful (and critical) lift to overall economic activity at a time when other growth drivers, like fiscal spending are slowing.

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